Banking auditors are watching carefully to ensure bank valuations based on in-house mathematical models are not, in the phrase coined by Warren Buffett, "mark to myth."
In the backwash of the credit crisis, U.S. and European banks have revealed more than $50 billion of writedowns and losses from U.S. subprime mortgage loans, leveraged loan commitments and other assets since the end of August.
Big chunks of those writedowns are based on mark-to-model valuations, which banks must justify to their auditors.
"You are definitely seeing an environment in which the audit firms are being more rigid and conservative in their approach to valuation," Alex Willmot-Sitwell, co-head of global investmentbanking at UBS, said at a Reuters Summit earlier this month.
"I think that's inevitable in an environment where there is bound to be a greater degree of scrutiny and where we are all aware of the potential risks vis-a-vis litigation etc."
When a bank these days says it expects no more writedowns, reputations are on the line, and such a statement is credible, although it is still subject to later market shifts that are out of a bank's control, said John Hitchins, UK banking leader at PricewaterhouseCoopers.
Valuing assets is a particularly tough job this year after the bottom fell out of the market for collateralised debt obligations (CDOs) and other complex structured credit products.
A CDO is a portfolio of credits that has been divided into tranches. At the bottom, the riskiest so-called equity tranche is exposed to the first few percent of default losses from anything in the portfolio, while the top tranche loses only after the rest of the portfolio has gone under.
The value of a single tranche is based on the market's view of the value of one tranche versus another, known as correlation risk, in addition to the values of all the underlying assets.
CDOs have been created from a variety of assets and with many structural tweaks and twists, making price comparisons difficult from one to another. When the underlying assets are also tranched products, such as U.S. subprime mortgage-backed securities, that adds another layer of complexity.
But the real problem is that few CDOs have traded in the market since the crisis, and many of the trades have been forced sales by funds or structured investment vehicles (SIVs) to meet investor redemptions or pay off short-term creditors.
For some CDOs, the only buyer, and a reluctant one at that, has been the bank that created and sold it in the first place.
"Banks are not in the business of holding these products for ourselves," said a senior European banker. "What is the value of a tennis racket for a rugby player? That means the few market prices available for comparison for many CDOs are based on fire-sale conditions.
Nevertheless, "if there is a price out there, it cannot be ignored," said Colin Martin, a partner at KMPG's FS Technical Advisory. It is extremely difficult to prove that prices are the result of a fire sale, he added.
If a hedge fund sells at 35 cents on the dollar when a bank sees the value at 65, or if the last comparable trade took place weeks ago, "you can't ignore that a trade has happened," said an accountant at a major European bank.
"It is very difficult to overcome an actual price ... You have to find some other evidence why that price is not valid."
The Bigger Problem
Even without market prices, banks still are expected to look to the market for any other data available to serve as inputs into their valuation models.
The biggest question mark involves assets for which the banks do not even have market-determined inputs and must use their own assumptions instead.
Take super senior tranches at the top of many CDOs. Bankers say these have not traded, but still there is agreement that their values have dropped based on models. Banks are valuing billions of dollars of these tranches and taking writedowns on them based purely on their models.
"What we are keen to see is that the models are consistent in building in current market conditions and risks to come up with prices, and this is inherently difficult in circumstances where a market breaks down," KPMG's Martin said.
Auditors say they are talking to each other to compare the results of one bank's model with another's.
"Auditors generally have a rule of thumb that if there is a difference over about 5 percent, you start looking closely at it ... but there is no hard and fast rule," Hitchins said.
"To be honest, the way some of this is going, I can see the argument that banks are writing too much off, rather than not enough," he said. "Once you've got a disaster, there is a
tendency to throw in the kitchen sink." A bank that sees market expectations for $2 billion in
writedowns and knows the figure is heading toward $3 billion, for example, is likely to opt for $3.5 billion to give itself a cushion against future writedowns.
The auditor's role is to head off excesses in either direction, Hitchins said, though "in practice people tend to allow for a little conservatism."